Are You a SaaS Startup? Private Equity May Soon Be Coming For You

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[Updated 3:16 p.m. See below.] More money than ever is flowing into software companies that offer anything from niche applications to more general cloud storage services, customer relationship tools, and more.

So far this year, the amount of venture capital funding invested in these software-as-a-service (SaaS) businesses tops $12 billion, according to data compiled by analytics firm Pitchbook for Xconomy. If that pace continues, it should beat out the $22 billion invested in 2015, which was the biggest year for SaaS investment since at least 2006, according to the Pitchbook data.

Mercury Fund, an early stage venture firm with offices in Houston, TX and Ann Arbor, MI, is one of those investors, focusing on funding SaaS, cloud services, and data analytics companies that have some sort of stable recurring revenue and often create products for other businesses, says managing director Blair Garrou. Mercury puts as much as $8 million into its investments over their lifetime, and makes about 12 to 14 investments annually, particularly in companies in the middle of the U.S. and not in the coastal high-tech hubs where there are too many overvalued businesses, Garrou says.

Most of the firm’s portfolio companies have some sort of recurring revenue, Garrou says. One reason Mercury is looking for businesses like that is because it believes that one type of buyer is particularly interested in software companies that show fast, reliable growth: private equity firms.

Private equity investors have an unprecedented level of money to deploy, Garrou says, as institutional investors and other limited partners look to get returns from the private market. Garrou is right that there’s lots of money in the hands of PE firms (and venture firms too): Pitchbook reported in March that private equity and venture capital firms were sitting on more than $1 trillion worldwide that could be invested. Private equity firms alone have $553.19 billion of dry powder (cash available for investing), up from $500.34 billion last year, according to data compiled by PitchBook. [Updated to add PE data.]

Garrou’s believes that PE firms will chase SaaS startups with that money—particularly mid-sized companies valued at $80 million to $100 million that sell their products to businesses—and then let the companies continue growing for three to five years until the PE firms can get a return from some type of exit.

“SaaS companies have hard metrics, and automated marketing and sales strategies that are very easy for private equity to get their hands around,” Garrou contends, adding that he expects most of Mercury’s future exits to be the result of PE buyouts. “The entire private equity business has turned their eyes to these software companies.”

Numbers from Pitchbook about private equity deals in SaaS do support the story, to an extent. So far in 2017, there has been $14 billion worth of PE buyouts—an amount that, if the pace continues for the rest of the year, would be the lowest annual deal total since 2012. (There were $41 billion worth of deals last year, and $103 billion in 2016.) But there appear to be a greater number of deals happening so far in 2018, which would mean the deal size is smaller. Halfway through 2018, there have been 125 PE buyouts, compared with 242 for all of 2017 and 182 in 2016.

Another reason for the interest in tech firms is that it’s taking longer for tech companies to reach the size at which they can seek an initial public offering, says Pat Matthews, another venture investor whose San Antonio, TX-based firm Active Capital also seeks out early stage SaaS startups that sell their software to businesses. Private equity fills that space, he says. An example is Austin, TX-based WordPress hosting startup WP Engine, which took a $250 million investment from private equity firm Silver Lake in January.

“I think this is starting to happen more and more,” Matthews wrote in an e-mail.

Garrou also mentioned WP Engine as a prime example of a good return for the venture capital investors (WP Engine’s investors included Austin-based Silverton Partners).

“With the WP Engine recap, it shows you don’t have to have a ‘traditional exit’ to have the venture capital firm paid back and also have individual entrepreneurs make money,” Garrou says.

The number of investors targeting SaaS businesses has been growing in Texas. In addition to Active Capital, San Antonio-based Scaleworks and Dura Holdings, as well as Austin-based BuildGroup, are all interested in similar companies, though they have different business models. Garrou says he expects to see even more open up shop in coming years.

Garrou says he believes the SaaS sector can withstand an economic downturn (something that of course makes sense for him to say, since Garrou has a stake in the industry’s success). Part of the reason for the belief is that private equity has enough money to continue buying SaaS businesses despite an economic downturn, even if they buy them for a lower multiple, he says.

“They’re going to keep investing,” Garrou says. “It’s not like the private equity firms are going to hand the capital back to their institutional investors.”

David Holley is Xconomy's national correspondent based in Austin, TX. You can reach him at dholley@xconomy.com Follow @xconholley